The Evolution of Monetary Theory and Practice

The Functions of Money: A medium of Exchange - Eliminates the

inefficiencies of barter, A unit of account, A store of value
Shiela Dow Seven stages of Financial Development
Stage 1: Commodity Money
Stage 2: Fiat Money
Stage 3: Fractional Banking Money
Stage 4: Fractional Banking Money + Central Bank Lender of Last Resort
Stage 5: Liability Management (endogenous- created from within)
Stage 6: Securitisation
Stage 7: Market diffusion (innovation)

Central Banking and Monetary Policy

Objectives of Monetary policy: the stability of the currency of Australia; the

maintenance of full employment in Australia; and the economic prosperity
and welfare of the people of Australia. inflation 2-3 %
The RBA publishes 4 Statements on Monetary Policy each year. The
Governor of the RBA appears before the House of Representatives
Standing Committee on Economics, Finance and Public Administration
twice a year
OMO: On surplus ES days by selling CGS (Commonwealth Government
Securities) or by entering into (the selling leg of) repurchase agreements.
On deficit ES days by buying CGS or by entering into (the buying leg of)
repurchase agreements.
The RBA has credibility. Market players know the new cash rate will be
achieved so they move to this rate more or less at the same time the
change to the target cash rate (the change in monetary policy) is
announced.
MP impacts through 1. saving and investment 2. cash flow 3. Money and
credit 4. Asset prices 5. Exchange rate

Money Markets

There is no central marketplace for money markets. Deals are all over the
counter and take place via telephone and trading screens.
Treasury Notes - T-Notes are short-dated commonwealth government
instruments of less than one year to maturity (traditionally 13 and 26
weeks).Usually sold in $1 million multiples. No default risk as close to
risk free as a security can get. There was a hiatus in the issuing of T-Notes
in Australia from 2003 to 2009. pure discount securities
Commercial Notes -Its modern form as short-dated debt instruments
issued by corporates, like T-notes are pure discount securities.
Negotiable Certificates of Deposit (CDs) - In essence, a bank deposit that
is tradeable (negotiable). The denominational range of CDs in Australia
is from $100,000 to $10m, but in practice few are for less than $500,000.

Most have a maturity of < 3 months, but technically they can be issued for
up to 33 months.
Note that we could expect that the yield paid by banks on CDs should be
below that paid on commercial paper, but a little higher than that on TNotes
yields: T-notes < CD's < commercial paper, This is a consequence of the
higher ratings banks typically enjoy.
Bank-Accepted Bills - Essentially identical to commercial paper, but
bearing the guarantee, endorsement, acceptance of a bank.
Following the collapse of Lehman Bros, the commercial paper market
around the world almost completely dried up.
To try to alleviate the problem, in October 2008 the US Fed introduced a
Commercial Paper Funding Facility (CPFF) to try to help companies issue
short-term debt. It provided support, however, only to AA rated paper and
above.
In 2014 the commercial paper market is essentially back to the status quo
ante, but (as with many financial markets) a certain wariness persists.
Bond Market

Corporate bonds are either secured against assets, or not. Unsecured

notes (as unsecured bonds are mostly called) have no specific collateral
backing. Debentures (as secured bonds are known) are backed by
collateral in one of two ways: 1. Floating charge debentures
2. Fixed
charge debentures
Some bonds are backed by a specified sinking fund into which a certain
proportion of the face value of a bond is paid each year (these were very
important historically).
Hybrid Securities as their name implies, securities that have
characteristics of both debt and equity.
A major type of such a security are convertible notes unsecured notes
convertible into common stock at the behest of the holder. Allows
investors to reap benefits of rising stock prices, while delivering lower
interest payments to issuers.
Covered Bonds- New security in Australia allowed to enable Aus Banks
to issue deposit-backed securities in (mostly) international wholesale
funding markets. Have delivered lower yields than otherwise payable by
Aus banks.
Who invests in corporate bonds? In Australia, superannuation and life
insurance firms are especially dominant (note the asset/liability matching
virtue). Much overseas investment too.
BBB is the minimum investment grade. The ratings go down to D in this
sliding scale, the latter of which represents securities in which payment is
in default. In normal circumstances the premium paid over the lowest to
highest of the investment grades is only about 1%.
The secondary market for corporate bonds is not very liquid in Australia,
and trading is rather thin.

Consols: (from Consolidated). Perpetual, no maturity date, could only be

bought back by govt if price equalled or exceeded par
Junk (High Yield) Bonds - The junk bond market is relatively small in
Australia and whats in it are mostly securities that never started out in
it! Are bonds with a credit rating for default risk that is below investment
grade (therefore, precluding some categories of investment).
Securitisation the conversion of illiquid assets (eg, loans) into liquid ones
that can be bought and sold in financial markets.
The primary regulator of the bond market in Australia (in its various forms)
is the Australian Securities and Investments Commission (ASIC).
Firms wishing to issue bonds to the public must submit a prospectus to
ASIC, contains: The use of funds raised, Issuers financial statements, Any
material information of relevance to ability to repay.
US government securities: Treasury Bills (money market securities,
equivalent to our treasury notes, maturity < 1 yr). Treasury Notes bonds
with a maturity of 1 to 10 years (not to be confused with our money
market securities of the same name). Treasury Bonds bonds with a
maturity of 10 to 30 years.

Equity Markets

Have tended to follow Kindlebergers five stage pattern: 1. There is a

change in the real economy (technology, productive processes) which
creates new opportunities. 2. There is rapid growth in the prices of shares
of companies connected to these developments. 3. The demonstration of
capital gains starts a feed-back loop, and new and (sometimes)
unscrupulous investors come in. 4. There is realisation that share prices
have risen to levels not justified by likely profits. 5. There is a rush for the
exit the bubble bursts
Exchange Traded Funds- First created in 1992 with the SPDR (Spider) of
State Street that tracked the S&P 500.
High Frequency Trading (HFT) uses super quick fibre-optic cables and
computer-generated algorithims to buy and sell stocks at great speed!
Half of all trading?, Biggest danger that others may lose confidence in a
market they perceive as being rigged against them.

Derivatives and Options Market

mark to market, and to provide the exchange daily with the cash a
movement in price may have cost them.
RBA and APRA regulate SFE (Sydney Futures Exchange)
A Credit Default Swap CDS is, in essence, an insurance contract against
the default of underlying securities issuer, CDS can be issued in greater
quantities than the assets they are derived from indeed, their issue can

be unlimited - $US60 trillion. CDS were sold not just by insurance

companies but, essentially by anyone who wanted to sell them and could
find a buyer.

Interest Rates

Loanable funds Theory (LFT) - orthodox approach, a real concept that

uses supply and demand for savings, classic supply and demand diagram,
long run model built in stability
Liquidity Preference Theory (LPT) - Keynes approach in General Theory,
preference between highly liquid assest (money) and illiquid assets
(bonds)
Yield Curve- normal higher yield higher maturity,
Pure Expectations Theory (PET) - yield curve determined solely by interest
rate expectations, Buying a single n-year bond will yield precisely the
same return as n 1 year bonds.
Liquidity Premium Theory (LPT) - Investors do not regard securities of
different maturities as perfect substitutes, Because of this, longer dated
securities must pay a risk premium, the yield curve will more likely slope
upwards than downwards thus, this is the normal yield curve, buying a
single n-year bond will NOT yield the same return as n 1 year bonds.
Modified Expectations Theory (MET) says that interest rates are impacted
upon by both expectations, and risk premiums.
Market Segmentation Theory (MST) suggests that the market for securities
is highly segmented. Some investors desire to hold short-dated securities,
some long-dated, and the interest rate has very little impact on this
decision. In other words, long-dated and short-dated securities are not
substitutes.
Preferred Habitat Theory (PHT) there are preferred habitats investors like
to dwell in, but they are not absolute.

Behavioural Finance

heuristic decision making - rule of thumb/mental shorts Representativeness, Overconfidence, gambler's fallacy, anchoring,
availability bias, left hand digits.
Prospect Theory - how we frame decision making - Myopic Loss Aversion,
Regret Aversion, Mental Accounting, Self-Control
Social Psychology - Peer Group Dynamics, Social Mood

Efficient Markets Hypothesis

Arbitrage and Speculation act as counters to keep EMH or do they?

Critics to EMH - rational bubbles, irrational behaviour, destabilising rational
speculation, informational deficiencies
Alternative theoretical approach - long-term assets are converted into
short-term ones via liquid financial markets
Robert Schiller - volatility has been far too high to be attributable to new
information adhering to EMH.
Robert Samuelson - Markets like those for equities he thought were micro
efficient (stocks were priced correctly relative to each other), but macro
inefficient (prolonged aggregate deviation from fundamental value).

Crypto-Currencies, Crime and Terror

Bitcoins are emoney that is recorded on a giant ledger (blockchain)

and can be sent from one person to another anonymously. Its status
of a currency is questionable due to its volatility and its constant
fallback comparison to US dollar. Has a set limit of 21M which has a
deflationary effect instead of common inflation of current currency.
Financial Action Taskforce (FATF), an autonomous body founded by
the OECD
In Australia, the AML/CTF framework is given legislative authority
via the 2006 AML/CTF Act. It is effectively run however, by
AUSTRAC AUSTRAC was established in 1988 (under the Financial
Transaction Reports Act) - 1. report suspicious matters (24hours
terr) 2. Threshold transaction reports (over 10000)
"Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of
2001." Section 311: Special Measures for
Jurisdictions, Financial Institutions, or International Transactions of
Primary Money Laundering Concern, Section 312: Special Due
Diligence for Correspondent Accounts and Private Banking
Accounts, Section 319(b): Bank Records Related to Anti-Money
Laundering Programs, Section 359: Reporting of Suspicious
Activities by Underground Banking Systems

Essay Topics

Behaviour finance vs EMH

Interest rate determination and term structure (diagrams)
Monetary policy
Credit default swaps - GFC
Bitcoin as a currency